Norgas Distributing Company

by
Peter Tryfos
Schulich School of Business
York University



The author is grateful to Mr. Steven Law, whose study of forecasting the demand for natural gas gave birth to this case, and to the Consumers' Gas Company Ltd. (especially to Ms. Janet Holder and Mr. John Rice) for background information that made this case possible.


Introduction and overview
The Norgas Distributing Company is the sole distributor of natural gas in the Kingstown Metropolitan area and surrounding region. The region, located along the northern shores of the Great Lakes, has an area the size of Rhode Island and a population of about 3.5 million.
Your task will be to manage the operations of Norgas for a period of one fiscal year, beginning on April 1st, 19Y5, and ending on March 31st, 19Y6.
The management of operations involves a number of irrevocable commitments, to be made by April 1st, 19Y5. A contract has to be arranged with suppliers, specifying the minimum total quantity of natural gas that will be purchased during the year. A contract has to be arranged with the pipeline specifying the maximum quantity to be transported on any day. A decision has to be made as to whether or not to purchase weather forecasts; if this decision is affirmative, one of two firms providing weather forecasts must be selected, and a binding contract signed with the chosen firm. Commitments must also be made concerning the method by which the daily demand for natural gas will be forecast and the order for next day's gas supply determined. A further issue that must be resolved is whether or not to use storage facilities for gas that will become available on April 1st, 19Y5, and, if so, how best to utilize these facilities.
Once these commitments have been made, the year's operations can be carried out automatically and the resulting profit calculated. Your final grade will depend in part on the profit you achieve.

Natural gas in Canada
Canadian reserves of natural gas This section and the next draw heavily from two publications: [1] Ontario Ministry of Energy, Natural Gas Storage in Ontario (a report prepared by Monenco Consultants Limited), July 1986; and [2] Ontario Ministry of Energy, Ontario Energy Review, 4th Edition, March 1990. are found in the Western Sedimentary Basin, a geologic formation that covers most of Alberta, southern Saskatchewan, southwestern Manitoba, and northeastern British Columbia. The reserves in western Canada are estimated to last less than 30 years at current production rates. Additional reserves, as yet unexploited, are located in the Arctic islands, the Mackenzie Delta, and the Atlantic coast. Figure 1 shows the location of reserves and the network of pipelines that brings natural gas to consumers.
Natural gas is found in fields ranging in size from one to several hundred wells. After some preliminary processing, the gas from each well is gathered into a field pipeline system and delivered to a central processing plant, where acid gases and valuable ethane, propane, butane or natural gasoline still contained in the gas are removed.
Gas produced in Alberta then passes into the NOVA pipeline system. That portion moving east is carried to a point near Empress on the Alberta-Saskatchewan border where it enters the TransCanada PipeLines System (TCPL).
TransCanada operates one of the world’s longest systems, carrying natural gas to markets in the United States and eastern Canada. The TransCanada pipeline runs through Saskatchewan, Manitoba, Ontario and Quebec. A southern line, operated by the Great Lakes Gas Transmission Company (itself partly owned by TransCanada), branches off the TransCanada pipeline in Manitoba and runs through Minnesota, Wisconsin and Michigan, connecting again with the northern pipeline near Sarnia, Ontario. The TransCanada system consists of more that 10,600 kilometers of pipe. The movement of gas requires high pressures that are maintained by compression stations along the route. It takes about six days for gas to travel from Alberta to Montreal, at a speed of about 30 kilometers per hour.

Figure 1
Canadian reserves of natural gas and pipelines, [2, p.19]

The last elements of the gas delivery system are lines connecting the TransCanada pipeline with local gas utilities and their storage facilities, and other lines under towns and cities that carry gas to residential, commercial and industrial users.

Natural gas in Ontario
Ontario's production of natural gas amounts to less than 3 percent of the provincial consumption. The relatively small Ontario reserves are located in the extreme southwest of the province and under Lake Erie. An additional 1 percent of the provincial consumption is supplied by synthetic natural gas manufactured at the Petrosar (now Nova) refinery in Sarnia. Figure 2 shows the Ontario gas distribution system.
Industry accounts for about 45%, residences for 29%, and commercial establishments for 18% of the total gas consumption in Ontario. Another 8% is consumed by the energy industry itself for such uses as pipeline compression and electricity generation.
There are three major gas distributors in Ontario. The Consumers' Gas Company Ltd. serves three regions: the central region includes the Metropolitan Toronto region and runs from Mississauga and Brampton on the west, to Bowmanville and Peterborough on the East, and to Collingwood and Barrie in the north; the Niagara region includes St. Catharines, Niagara Falls, Niagara-on-the-Lake, Welland and Fort Erie; finally, the Ottawa region includes also Petawawa, Brockville, and Hawkesbury. The southwestern part of Ontario, from Sarnia and Windsor in the west to Oakville in the east and Owen Sound to the north, is served by Union Gas Limited. ICG Utilities (Ontario) Ltd. serves a large area of northern Ontario along the route of the northern TransCanada pipeline.
Smaller areas are served by Natural Resource Gas Limited, the Wellandport Gas Company, the Corporation of the City of Kitchener, and the Kingston Public Utilities Commission.

Figure 2
Ontario gas distribution system [2, p. 20]

About one-fifth of the annual gas consumption in the province can be stored underground. Most storage facilities are depleted gas fields and are located in southwestern Ontario. Because gas can be stored in the summer and withdrawn in the winter, it is possible to maintain a nearly constant throughput on the TransCanada pipeline. The resulting high utilization rate of the pipeline is one of the reasons for the relatively low cost of natural gas in Ontario.
Apart from Ontario, natural gas in Canada is stored underground only in Alberta and Saskatchewan. The Ontario storage facilities are owned by Union Gas, Tecumseh Gas Storage Limited (itself owned equally by Consumers' Gas and Imperial Oil Limited), Consumers' Gas, and ICG.

Norgas: General
The Norgas Distributing Company is a corporation with assets of $1.8 billion and shareholders' equity of $560 million. It employs about 2,800 people. For the 19Y5-Y6 fiscal year beginning April 1, 19Y5, the company projects a net revenue (i.e., difference between gas revenue and cost) of about $475 million. Total expenses for 19Y5-Y6 (including operating expenses, financial charges and depreciation) amount to $420 million. The forecast is thus for a net profit before taxes of $55 million and a return on shareholders' equity of about 9.8%.

Norgas: Purchase and transportation
Norgas buys natural gas from a major western gas marketing organization and has this gas transported to its central distribution facility by pipeline.
As in past years, Norgas intends to contract with the supplier and with the pipeline to ensure enough gas will be available to meet its customers' requirements during the year beginning April 1, 19Y5.
Purchasing and transportation are governed by two different contracts, but together these essentially stipulate two key quantities In this case, all quantities of gas are measured in thousands of cubic meters, abbreviated as Km3.: Norgas cannot have more than D delivered on any day, and must purchase no less than A during the year. If the actual annual purchases are less than A, Norgas must pay for the difference at the end of the year.
The cost of transporting Q Km3 of natural gas on any day from the supplier's gate to Norgas's central distribution point is given by aQ+bD where a =$13.32 and b = $26.51.
The unit purchase cost of gas at the western supplier's gate, c, depends on the annual purchase commitment. It is $92 per Km3 if A is less than 8 million Km3, $90 per Km3 if A is greater than 12 million, and, if A is between 8 and 12 million Km3, is given by c=96-0.5A', where A' is A expressed in million Km3. For example, if A=9,100,000 Km3, c=96-(0.5)(9.1)=91.45.
It follows that the cost of purchasing Q Km3 of gas on any day and having it transported to Norgas's central distribution point is (a+c)Q+bD.

Norgas: Daily demand
Natural gas is used throughout the year for cooking and water heating in residences and as a source of power in industry. In the winter months, natural gas is also used for space heating. The daily demand for space heating depends on the weather. The daily demand for other uses depends mainly on household habits and the level of industrial activity.
The retail price of natural gas is regulated, and must remain constant throughout the next fiscal year at an average The retail price of gas varies with the conditions of service provided, the type of user, and the volume purchased. Numerous “tariffs” exist, but the above average is considered satisfactory for planning purposes. of r=$211.78 per Km3.
In the short run, therefore, the daily demand for natural gas is a function of such weather characteristics as temperature, wind speed, hours of sunshine, humidity, etc.
It is the practice of Norgas to relate gas demand, not to the daily temperature, but to “degree days,” in the belief that gas demand is more closely related to degree days than to temperature. Degree days is equal to the number of degrees below a given base temperature if the day's temperature is below the base, or to zero if the day's temperature exceeds or is equal to the base temperature. In symbols,

t0 - TEMP, if TEMP < t0,
DDAY =
0, if TEMP t0,

where TEMP is temperature and t0 the base temperature. Practice varies concerning the base temperature used. Norgas uses 18o C, but other gas utilities use base temperatures in the range from 15o C to 20o C.

Consequences of excess demand or supply
At present, Norgas does not have access to gas storage. At the beginning of every day, it must place an order with its suppliers for delivery of the quantity of natural gas that will be required during the next day. For example, at the start of a Tuesday, an order must be placed for the quantity expected to be required during Wednesday.
If, as the day progresses, it becomes clear that the demand for the day is greater than the quantity ordered, Norgas curtails the demand by notifying and shutting off gas to interruptible customers For the purpose of this case, it can be assumed that the entire excess demand can be interrupted at no higher cost than the lost revenue. In practice, there is a limit to interruptible demand, and severe consequences to a gas utility which cannot satisfy uninterruptible demand.. Interruptible customers are generally large industrial and commercial users who can switch to another source of energy (e.g., oil) on short notice. Interruptible customers are compensated by paying a considerably lower rate than customers on “firm service.”
If, on the other hand, the demand for the day is less than the quantity ordered, Norgas must refuse delivery of the excess but pay for the entire quantity ordered.

Weather forecasts
In the past, Norgas relied on publicly available forecasts produced by the regional office of the Department of the Environment. Because of concerns about the accuracy and timeliness of these forecasts, Norgas decided to consider purchasing commercial forecasts only in the coming fiscal year.
Two commercial weather forecasting services are available, Orion and Polaris. Both provide at the start of each day forecasts of the average hourly temperature and of the average hourly wind speed during the following day. For example, forecasts of the average hourly temperature and wind speed for a Wednesday will be available at the start of the preceding Tuesday In the gas industry, a day starts at 8 a.m., and ends at 8 a.m. of the following calendar day. For example, “Wednesday” is the 24-hour period from 8 a.m. Wednesday to 8 a.m. Thursday..
Both Orion and Polaris supply forecasts on an annual subscription basis only. The cost of an annual subscription to Orion is $60,000, and that to Polaris $50,000.
By April 1, 19Y5, Norgas must decide which one of the two weather forecasting services will be its supplier of weather forecasts for the year. Of course, Norgas may elect not to buy weather forecasts at all, if it believes such forecasts are not necessary.

Daily operations illustrated
As noted earlier, a number of commitments must be made by April 1, 19Y5, including:
determine A, the minimum quantity of gas to be purchased during the year;
determine D, the maximum quantity of gas to be carried on the pipeline on any day of the year;
decide how to forecast next day's temperature, wind speed, and gas demand;
decide how to determine the quantity of gas to be delivered next day.
The daily revenue, purchase and transportation cost, and gross profit, as well as the totals of these variables for the fiscal year, depend on these commitments, the actual demand for gas, and other events beyond the control of Norgas. The spreadsheet shown in Figure 3 and filed under EXAMPL1.XLS illustrates the calculations.
The numbers used are purely for illustration. Several rows of the spreadsheet are hidden. It is assumed that Norgas continues not to make use of any gas storage facilities. It is also assumed that Norgas contracted to buy a total of A=900,000 Km3 of gas during the year, agreed to have no more than D=35,000 Km3 of gas transported on any day of the year, and decided to subscribe to the Polaris weather forecasts.
The purchase commitment implies that c=92 and that the cost of purchasing Q Km3 of gas on any day and having it transported to Norgas's central distribution point is
(92 +13.32)Q + (26.51) (35000),
or 927850+105.32Q.
At the start of any given day, Norgas will have available the Polaris forecast of temperature and wind for the following day. Figure 3 shows the forecasts on the day for which they were intended, even though they were made at the start of the previous day. For example, the forecasts of temperature and wind for April 2 were actually made at the start of April 1.

Figure 3
Illustrative spreadsheet, storage not used, EXAMPL1.XLS

It is further assumed that Norgas, despite having subscribed to the Polaris forecasts, decides to ignore them (this is not an especially good business decision, but the artificial example is intended to show variety rather than good judgment). Instead, Norgas has no use for wind forecasts and uses as its forecast of temperature the actual temperature of two days ago. It can be noted inFigure 3, for example, that Norgas's temperature forecast for April 3 is the actual temperature of April 1 (which is available at the start of April 2), and that for April 4 is the actual temperature of April 2 (available at the start of April 3).
In Figure 3, Norgas forecasts the demand for gas using the formula 8000 + 910 DDAY, where

18 - FTEMP, if FTEMP < 18,
DDAY= and FTEMP is Norgas's forecast of temperature.
For example, the forecast of gas demand for April 1 is
(8000) + (910)[18-(-7.8)] = 31,478 Km3,
as shown in the spreadsheet.
The quantity to order, Q, is made equal to the forecast demand if the latter is less than or equal to the maximum daily quantity, D, or to D otherwise. It can be noted, for example, that the order quantity is equal to the forecast demand on April 1 to 5, but to 35,000 on April 6.
Figure 3 next shows the actual temperature, wind, and gas demand (these events are, of course, beyond the control of Norgas).
Given Norgas's policies and these actual events, the day's sales, revenue, purchase and transportation cost, and gross profit are calculated, as shown in the last columns of the spreadsheet. Sales equals the smaller of the quantity ordered and demanded.
Pretend that the planning period is the month of April 19Y5, rather than the entire fiscal year. The total purchases over this period were less than the minimum quantity contracted for (900,000). The shortfall must be paid for at the rate of $92 per Km3; the adjustment reduces total gross profit by the amount shown in Figure 3. The other reductions of gross profit are for expenses ($420 million), the cost of the Polaris subscription ($50,000) and the acquisition of 10 years of data (explained below, and amounting to $15,000).
The spreadsheet shown in Figure 3 is filed as EXAMPL1.XLS. You may copy it to inspect how the cell entries are created and the calculations performed.

Gas storage
For some time, Selcan, a company with extensive mining rights, has been converting the underground caverns near Exeter into storage facilities for gas. These are depleted salt caverns, from which the original salt deposits were extracted by solution mining. As Figure 4 shows, these caverns are located close to the main pipeline from which Norgas draws its gas supply.


Figure 4
Selcan storage facilities


Selcan has announced its intention to finish by April 1, 19Y5, the construction of the Exeter storage facilities as well as the pipeline linking them to the main pipeline. The facilities will have a storage capacity of 3 million Km3. Additions to or withdrawals from storage cannot exceed 30,000 Km3 on any day.
There is strong interest in Norgas to examine the possible benefits of a long-term contract with Selcan. Norgas would be able to divert a part of a day's supply to storage, or supplement the day's supply with a quantity withdrawn from storage. Thus, Norgas could store gas during the summer months for use in winter months, thereby reducing the range of the daily order quantity and possibly achieving a lower purchase cost.
Norgas is not the only interested user of the Exeter storage pool. Other gas utilities in both directions from Exeter along the main pipeline have begun negotiations with Selcan.
Selcan's storage charges will depend on two quantities to be stipulated in the storage contract: S and T cannot exceed the pool's capacities. The daily storage charges, including transportation to and from the main pipeline, will be calculated using the formula fS+gT+hY, where In preliminary negotiations, Selcan informed Norgas that the unit charges will be f=$0.013, g=$2.29, and h=$2.94. These are preliminary quotations; the final unit costs will depend on the outcome of the current negotiations.

ASSIGNMENTS

(1) Ten years of data are available concerning the daily demand for gas, the actual daily temperature and wind speed, and the forecasts of these variables by Orion and Polaris. The data are in paper files and documents and must be retrieved, checked, transcribed and entered into a computer file. The cost of this operation is $1,500 per year of data.
(a) Decide how many years of recent data you want retrieved and entered into a computer file.
(b) Run the program NORGAS to have the requested data stored in a computer file for later analysis.
It is assumed that you will want the requested years to be consecutive and to end with the 19Y4-Y5 fiscal year. For example, if you specify 3 years, you will obtain data for the fiscal years 19Y2-Y3, 19Y3-Y4, and 19Y4-Y5, at a cost of $4,500.
Following is a partial listing of a file created by this program at the request of 10 years of data (your file will have different numbers). The names of the variables were added.

YEAR
MONTH
DAY
DOWEEK
FTO
FWO
FTP
FWP
TEMP
WIND
DEMAND
19X4
Apr
1
Fri
-5.8
11.1
-5.4
7.3
-6.0
10.2
30685.6
19X4
Apr
2
Sat
-3.0
14.7
-1.2
6.3
-5.8
10.5
31943.5
19X4
Apr
3
Sun
1.3
17.2
-1.9
18.8
-1.7
13.6
29414.5
19X4
Apr
4
Mon
2.7
7.2
5.0
15.4
2.1
5.7
23053.1
19X4
Apr
5
Tue
5.1
7.7
3.5
4.3
1.6
5.1
23377.1
19X4
Apr
6
Wed
1.1
5.3
2.1
11.3
2.4
9.2
19523.7
19X4
Apr
7
Thu
7.8
10.8
4.6
14.6
4.8
7.4
16574.1
19X4
Apr
8
Fri
5.1
14.1
8.0
21.8
5.9
17.3
16013.8
19X4
Apr
9
Sat
1.9
16.6
1.1
14.9
2.7
13.6
17950.3
19X4
Apr
10
Sun
7.1
16.6
9.0
9.1
8.9
9.7
12997.1

FTO and FWO are the Orion, and FTP and FWP the Polaris forecasts of the day's temperature and wind speed, respectively, measured in the same units as TEMP and WIND: Your decision concerning the number of years of data cannot be changed. You must preserve and protect your data, because they cannot be replaced without penalty.

(2) In the data file created in Assignment (1), FTO and FWO are the Orion, and FTP and FWP the Polaris forecasts of the day's temperature and wind speed, respectively, measured in the same units as TEMP and WIND.
These forecasts are made, of course, at the start of the day prior to the one with which they are listed. For example, the Wednesday forecasts are made at the start of Tuesday. It will be recalled that the cost of an annual subscription to the Orion forecasts is $60,000, and that to the Polaris forecasts $50,000.
In a report addressed to the management of Norgas, (a) state if Norgas should subscribe to (i) the Orion forecasts, (ii) the Polaris forecasts, or (iii) neither forecasting service, and (b) fully explain the reasons for your recommendation.
If your recommendation is (a, iii) or if your forecasts of temperature and wind speed are to be different from those of the selected weather forecasting service, explain precisely how your forecasts will be formed.

(3) In a report addressed to the management of Norgas, (a) state clearly the method you recommend for forecasting the daily demand for gas (in Km3), and (b) fully explain the reasons for your recommendation.
The method in (a) must be stated in the form of formulas that can be implemented in a spreadsheet program.

(4) Assume that Norgas will not make use of Selcan's gas storage facilities. The quantity to order, Q, will be made equal to the forecast demand if the latter is less than or equal to the maximum daily quantity, D, or to D otherwise. In a report addressed to the management of Norgas,
(a) state your decisions concerning (b) fully explain the reasons for your decisions.
Attach to your report a copy of the file EXAMPL1.XLS, with the original formulas for creating the forecast and decision variables replaced by others implementing your recommendations in Assignments (2) to (4). Your formulas should not make use of information that is not known at the time the forecasts and decisions are made.
As a result of your decisions in Assignments (1) to (4), and given the actual gas demand each day from April 1, 19Y5, to March 31, 19Y6, the daily revenue, purchase and transportation cost, and gross profit, as well as the total profit for the year can be calculated. This last figure measures the performance of Norgas under your directions if the gas storage facilities are not used.

(5) Assume that Norgas will want to make use of Selcan's gas storage facilities. Consider a plan whereby Norgas will order from its western supplier a constant quantity of gas (Q) each day, divert any portion that is not needed into storage, or supplement Q with a quantity withdrawn from storage if more than Q is needed. In a report addressed to the management of Norgas,
(a) state clearly your recommendations concerning D (the maximum quantity that may be transported on any day), S (the maximum quantity to be stored), T (the maximum quantity to be added to or withdrawn from storage on any day), and Q; and
(b) fully explain the reasons for your recommendations.
The annual quantity of gas purchased is A=365Q, that is, A is implied by Q and is not a decision variable. Neither the order quantity Q nor the quantity available for sale each day (equals Q minus additions to storage plus withdrawals from storage) may exceed D.
The spreadsheet shown in Figure 5 is filed as EXAMPL2.XLS. You may copy it to inspect how the cell entries are created and the calculations performed.

The numbers were also used in Figure 3 and are for illustration only. Some columns are hidden. The values of the decision variables D, S, T, and Q are arbitrary. It is assumed that the initial quantity of gas in storage is zero, that gas is added to storage when the excess supply (the difference between Q and the forecast demand) is positive, and withdrawn from storage when it is negative---subject, of course, to the storage constraints. It is also assumed that the quantity withdrawn from storage ( W ) can be adjusted so that no stored gas is wasted (see formula determining W in EXAMPL2.XLS).
Attach to your report a copy of the file EXAMPL2.XLS, with the original formulas for creating the forecast and decision variables replaced by others implementing your recommendations in Assignments (2), (3) and (5). Your formulas should not make use of information that is not known at the time the forecasts and decisions are made.
As a result of your decisions in Assignments (1) to (3) and (5), and given the actual gas demand each day from April 1, 19Y5, to March 31, 19Y6, the daily revenue, purchase and transportation cost, and gross profit, as well as the total profit for the year can be calculated. This last figure measures the performance of Norgas under your directions if the gas storage facilities are used according to the plan of this assignment.

(6) In a report addressed to the management of Norgas,
(a) state clearly your recommendations concerning the optimal (i) source of weather forecasts, A (the minimum total quantity to purchase during the year), D (the maximum quantity that may be transported on any day), S (the maximum quantity to be stored), and T (the maximum quantity to be added to or withdrawn from storage on any day); (ii) the methods to be used for forecasting temperature, wind speed, and gas demand, for determining additions to or withdrawals from storage and Q (the order quantity, now allowed to vary from day to day); and
(b) fully explain the reasons for your recommendations.
The methods in (a, ii) must be stated in the form of formulas that can be implemented in a spreadsheet program.
Modify and attach to your report a copy of the file EXAMPL2.XLS, with the original formulas for creating the forecast and decision variables replaced by others implementing your recommendations in Assignments (2), (3) and (6). Your formulas should not make use of information that is not known at the time the forecasts and decisions are made.
As a result of your decisions in Assignments (2) (3) and (6), and given the actual gas demand each day from April 1, 19Y5, to March 31, 19Y6, the daily revenue, purchase and transportation cost, and gross profit, as well as the total profit for the year can be calculated. This last figure measures the best possible performance of Norgas under your directions.


Figure 5
Illustrative spreadsheet, storage used, EXAMPL2.XLS





APPENDIX A
COMPUTING INSTRUCTIONS



To run the program NORGAS:
a. Go to DOS or the MS-DOS window;
b. Type NORGAS, hit Enter;
c. At the appropriate prompts,
- enter your password;
- insert a formatted blank diskette in Drive A;
- enter the number of years of data you wish to obtain;
- wait until the program counter reaches 0 and a message appears to the effect that the file NORGAS.DAT was created.

The conversation with the program is as follows (user input is underlined):

The file NORGAS.DAT is a text (ASCII) file containing your data. Take care of this file because it cannot be replaced without penalty.